+1.84(+0.12%)

-0.70(-1.13%)

-9.00(-0.68%)

-0.23(-1.37%)

-0.00(-0.04%)

Why Frontier Markets ETFs are Still Attractive

Emerging markets have been in the limelight due to their stellar performance in the past few years but they have lost their luster lately. So far in 2013, many emerging markets suffered steep declines, mainly due to the ‘taper talk, which is making investors reconsider emerging markets in general.

Beyond the taper, current account deficits and political woes have also impacted these markets. Investors are growing concerned about the political situation in many countries, in addition to rising inflation and growing current account deficits.

Many nations in this space have seen their benchmarks fall by double digits, pushing a number of developing nations into crash territory. Lately, emerging country funds from India, Indonesia, Thailand, Turkey and China have been struggling with weak numbers. (Read: Time to Panic About Emerging Markets?)

On the other hand, many smaller emerging markets or frontier markets have managed to remain rather unaffected by the turmoil in the broader emerging markets space.

About Frontier Markets

Frontier markets include countries that are in the early stages of economic development and are less established and developed than emerging nations. When compared to emerging markets, frontier markets have low market capitalization and liquidity (Read: Frontier Markets: A Better Choice for ETF Investors?).

Moreover, frontier markets have a low correlation with the developed markets which may benefit investors at a time when investing in emerging nations isn’t fruitful. Further, they have relatively lower valuations as well as higher income yield.

One of the reasons for outperformance of frontier markets is the currency factor. ETFs tracking frontier markets are dominated by Middle East countries. Many of these countries peg their currencies to the US dollar or to a basket dominated by the US dollar. As such these currencies have remained steady while currencies of most emerging markets have suffered a lot of pain. Currency losses have been a big factor is emerging markets’ poor performance.

Further, during its latest classification review MSCI promoted UAE and Qatar to emerging market status from frontier market. The upgrade resulted in increase in capital flows to the Middle East region.

Why should you play here?

Of late, frontier funds have amassed $1.5 billion in assets this year in contrast to steep outflows for many of the largest emerging market ETFs, reports Bank of America Merrill Lynch.

The space mostly benefits from the markets of Kuwait, Qatar and United Arab Emirates (:UAE) that are more focused on local demand and are free from global market risks (Read: Time for Frontier Markets ETFs?).

The Risks

Though the frontier markets provide a good investment strategy for those looking for attractive returns over the long term, a high level of volatility and poor liquidity are risks that run high in these markets. High inflation levels are also a headwind, as many have trouble keeping inflation under control.

How to play?

For investors who are willing to take some risk and seek to reap the benefits, we have highlighted two ETFs which track broader frontier markets space.

Launched in Sep 2012, FM tracks the MSCI Frontier Markets Index, which is ranked by float adjusted market capitalization. It is one of the most popular funds in the space and puts more focus in large cap securities. The fund has an asset base of $286.3 million and has an average daily trading volume of 115,000 shares a day.

The ETF holds 101 securities in its basket. The top ten holdings of the fund take almost 39% share in the basket. In terms of country exposure, Kuwait (25.75%), Qatar (19.02%) and the UAE (14.74%) are in the top three spots. Financials dominates in terms of sector exposure, accounting for a whopping 56% of the total assets, while Telecommunication (14.15%) and Industrials (11.56%) round out the top three.

The fund is a bit costly in the space, charging investors a hefty fee of 79 bps. However, the fund has given strong returns of over 17% year to date and also pays a 30-day SEC yield of 4.09%.

Launched in Jul 2008, PMNA tracks the NASDAQ OMX Middle East North Africa index, which seeks the performance of liquid companies in MENA (Middle East and North Africa) frontier countries. So far, the fund has amassed only $15.2 million in assets.

The fund holds 43 securities in its basket. The fund is more concentrated in its top 10 holdings as it puts nearly 55% share. Citadel Capital, National Bank of Kuwait and Union Land Development Corp. are the top three company holdings of the fund.

The ETF is tilted more towards Financials as it leads the sector with about 74% share, while Telecom and Industrials allocate a respective 14% and 8%. In terms of country exposure, Kuwait (23.53%), UAE (18.3%), Egypt (16.19%) and Qatar (15.17%) account for the majority of asset holdings.

The product charge investors 70 bps in fees. The fund has generated returns of 9.5% on a year-to-date basis and has a decent yield of 1.68% (Find all broad emerging markets ETFs) .